50-percent discount in accordance with its standard pricing policy. For example, the petitioner sold propellor governors and related equipment to Cessna Aircraft Co., Beech Aircraft Corp., and Piper Aircraft Corp. at list price less a 50-percent discount. The petitioner also sold propellor governors and related equipment to the Hamilton Standard Division of United Aircraft Corp. and gas turbine fuel controls to Westinghouse Eelctric Corp. at net prices which were equal to list price less a 50-percent discount.

Formation of GmbH

Prior to April 22, 1961, the petitioner made no sales of 1307's directly to GE's European licensees for the J-79 engine. All sales of 1307's had been made directly to GE, which, in turn, resold them to its J-79 licensees.

In 1961, the petitioner decided to enter into the European market for its 1307 controls through a wholly owned foreign subsidiary. Accordingly, on April 22, 1961, the petitioner organized Woodward Governor GmbH (GmbH) under the laws of the Swiss Confederation as a wholly owned subsidiary. GmbH's domicile was in Lucerne, Switzerland. The petitioner's initial investment for all quotas (equivalent to shares of stock in a domestic corporation) in GmbH was $23,255.81.

Operations of GmbH

Following its formation, GmbH (1) purchased 1307's from the petitioner for resale to GE's European licensees for the J-79 engine, and (2) sold in Europe, the Middle East, and Africa, on a commission basis, industrial engine and turbine controls manufactured in the petitioner's United States, Slough, and Schiphol plants. Prior to the formation of GmbH, the sales of the industrial engine and turbine controls were performed by employees of the petitioner's Slough and Schiphol plants.

GmbH reimbursed the petitioner for any accounting services and other services that may have been performed on its behalf by the petitioner.

Sales of 1307's to GmbH

Following the formation of GmbH, the petitioner decided to sell 1307's to GmbH at list price less a 50-percent discount, the same price at which they were sold to GE.

The petitioner began selling 1307's to GmbH shortly after the formation of GmbH, and these sales continued throughout the taxable year in issue and thereafter on a regular and continuing basis. The terms and conditions of the petitioner's sales of 1307's to GmbH were

the same as the terms and conditions of its sales of 1307's to GE. The petitioner's trademark was affixed to all 1307's sold to and by GmbH. At the time of GmbH's formation, the petitioner also had to decide upon a commission rate to be paid to GmbH with regard to sales of industrial engine and turbine controls consummated as a result of GmbH's selling activities. The petitioner decided that a commission equal to 6 percent of the net selling price of such controls represented a fair compensation to GmbH for its selling activities. This conclusion was based on the selling expenses with regard to similar sales in the United States, which slightly exceeded 5 percent of the net sales price of these products.

Sales and Service of 1307's by GmbH

Having purchased 1307's from the petitioner at list price less a 50-percent discount, GmbH offered 1307's for sale to GE's European licensees for the J-79 engine at the petitioner's list price less a discount of approximately 35 percent.

GmbH performed sales and service activities with regard to 1307's. These activities included personal visits to customers and potential customers; assistance in setting up test stands for 1307's for customers; training of customers' technicians as to overhauling, operating, and servicing 1307's; advising customers as to the types of spare parts inventories they should keep; advising customers as to the types of tools they needed; answering trouble-shooting calls; providing training films and cutaway governors; and performing crash investigations involving Starfighter aircraft.

GmbH and GE were in direct competition with each other for the sale of 1307's to GE's licensees in Europe. For example, GmbH attempted to make sales to the J-79 licensees of GE who were buying 1307's from GE. Similarly, GE attempted to sell 1307's to GmbH's principal customer for 1307's.

The first order received by GmbH was for seventy-three 1307's from Fabrique Nationale d'Armes de Guerre, S. A. (Fabrique Nationale), Belgium, a licensee of GE for the J-79 engine. This order was received by GmbH from Fabrique Nationale in May 1961, approximately 1 month after GmbH was organized. The negotiations with Fabrique Nationale with regard to this order took place prior to the formation of GmbH and were carried out by W. J. Whitehead, who at that time was the petitioner's vice president in charge of foreign operations. Mr. Whitehead advised Fabrique Nationale that it was the petitioner's intention to form a European subsidiary to handle all European sales of 1307's. Fabrique Nationale's order for the seventy-three 1307's was accepted and completed by GmbH. Delivery of such controls was

scheduled for 1962, prior to the beginning of the taxable year in issue. Fabrique Nationale was GmbH's principal customer for 1307's from the time of its formation throughout the taxable year in issue.

During the taxable year in issue, GmbH negotiated the conditions of sale, price, delivery date, and other terms of sale with regard to 1307's sold by it. All purchase orders for 1307's obtained through the sales efforts of GmbH were accepted by GmbH itself. GmbH passed title to, and assumed full risk of loss for, all 1307's sold by it, and it provided its customers with warranties against defects in materials. and workmanship. GmbH assumed sole responsibility for patent infringement suits against GmbH or the petitioner arising out of sales of 1307's by GmbH and agreed to indemnify the petitioner against all liability arising from the testing or use of 1307's.

Subsequent to 1963, GmbH sold 1307's to Mitsui in Japan, but the record does not reveal the circumstances surrounding the sales and service of such controls.

GmbH provided no postsales service or warranties with respect to its sales of nonaircraft controls as the agent of the petitioner.

Set forth below is an income statement for GmbH for its fiscal year ending September 30, 1963:

The issue for decision is whether the respondent was authorized under section 482 to reallocate certain income from GmbH to its parent company, the petitioner.

Section 482 provides:

SEC. 482. ALLOCATION OF INCOME AND DEDUCTIONS AMONG TAXPAYERS.

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests,

420-714-71—6

the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

The purpose of section 482, as interpreted by the respondent, is set forth in section 1.482-1(b) (1) of the Income Tax Regulations:

(b) Scope and purpose. (1) The purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true taxable income from the property and business of a controlled taxpayer. The interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the taxable income from the property and business of each of the controlled taxpayers. If, however, this has not been done, and the taxable incomes are thereby understated, the district director shall intervene, and, by making such distributions, apportionments, or allocations as he may deem necessary of gross income, deductions, credits, or allowances, or of any item or element affecting taxable income, between or among the controlled taxpayers constituting the group, shall determine the true taxable income of each controlled taxpayer. The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.

See Local Finance Corporation v. Commissioner, 407 F. 2d 629 (C.A. 7, 1969), affirming 48 T.C. 773 (1967). The petitioner invites us to hold that regulation invalid and to apply a test other than the arm's-length standard. However, in view of our conclusions in the case, it is unnecessary for us to deal with that argument—we shall apply the arm'slength standard.

In situations involving sales of tangible property between members of the same controlled group, three specific pricing methods are provided by the regulations to determine arm's-length price: The comparable uncontrolled price method; the resale price method; and the cost plus method. Sec. 1.482-2(e) (1) (ii), Income Tax Regs. If comparable uncontrolled sales exist, the regulations provide that the comparable uncontrolled price method must be utilized in determining the arm's-length price, "because it is the method likely to result in the most accurate estimate of an arm's length price." Sec. 1.482-2(e) (1) (ii). If no comparable uncontrolled sales exist, the resale price method must be used, if applicable, since it is considered more desirable than the cost plus method. Finally, if the resale price method is not applicable, the cost plus method must be used. If none of the three tests can reasonably be applied, "some [other] appropriate method of pricing *** can be used." Sec. 1.482-2 (e) (1) (iii).

The respondent takes the position that the sales to GE were not comparable to, and did not establish an arm's-length price for, the

sales to GmbH. He determined that in connection with the sales of the 1307's, GmbH acted merely as a commission agent, although he recognizes that it should receive a larger commission in connection with such sales than it received for its sales of the industrial engine and turbine controls. In his determination, he recomputed the income of GmbH by allowing it a 7-percent commission on such sales, and he reallocated to the petitioner the balance of the income shown by GmbH in connection with its sales of 1307's.

Section 482, by its terms, gives the respondent unlimited authority to reallocate income and other items when necessary to prevent tax evasion or to reflect income clearly. When his reallocation is challenged, the courts have upheld his action unless it is shown that he acted arbitrarily, unreasonably, or without justification. Ballentine Motor Co. v. Commissioner, 321 F. 2d 796 (C.A. 4, 1963), affirming 39 T.C. 348 (1962); Hall v. Commissioner, 294 F. 2d 82 (C.A. 5, 1961), affirming 32 T.C. 390 (1959); Grenada Industries, Inc., 17 T.C. 231 (1951), affd. 202 F. 2d 873 (C.A. 5, 1953), certiorari denied 346 U.S. 819 (1953). However, his action will not be upheld when it is found that there is no rational justification for such action. Nat Harrison Associates, Inc., 42 T.C. 601 (1964).

From the record before us, we have concluded that the evidence does not support the respondent's determination. The respondent claims to have applied the resale price method described in section 1.4822(e)(3) of the Income Tax Regulations; he refers to the provision in subdivision (vii) thereof indicating that the method may be applied when the reseller performs services similar to those of a sales agent. However, he takes that provision out of context. It is clear that the resale price method described in the regulations is not applicable to this situation. The objective of that pricing method is to determine the arm's-length price for controlled sales to a person who resells the product by reducing the resale price by the markup earned by resellers in uncontrolled purchases and sales. The method can only be applied when there are uncontrolled purchases and resales by the same reseller or a similar reseller. Similarly, although the method can be applied when the reseller is acting merely as a sales agent who receives a commission for its services, the commission must be established by reference to uncontrolled transactions. In this case, the respondent based his determination on the commissions charged by GmbH for its sales of industrial engine and turbine controls, but those sales did not involve uncontrolled transactions. The commissions were established by the petitioner, which controlled GmbH, and therefore, they do not provide a basis for applying the resale price method.

Even more importantly, the activities of GmbH in connection with the sales of the industrial engine and turbine controls and the sales of